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Chapter 4

The Valuation of
Long-Term
Securities
4.1

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

After studying Chapter 4,


you should be able to:
1.
2.
3.
4.

4.2

Distinguish among the various terms used to


express value.
Value bonds, preferred stocks, and common
stocks.
Calculate the rates of return (or yields) of
different types of long-term securities.
List and explain a number of observations
regarding the behavior of bond prices.

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Valuation of
Long-Term Securities

4.3

Distinctions Among Valuation


Concepts

Bond Valuation

Preferred Stock Valuation

Common Stock Valuation

Rates of Return (or Yields)


Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is Value?

4.4

Liquidation value represents the


amount of money that could be
realized if an asset or group of
assets is sold separately from its
operating organization.

Going-concern value represents the


amount a firm could be sold for as a
continuing operating business.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is Value?

Book value represents either:


(1) an asset: the accounting value of
an asset the assets cost minus
its accumulated depreciation;
(2) a firm: total assets minus liabilities
and preferred stock as listed on
the balance sheet.

4.5

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is Value?

4.6

Market value represents the


market price at which an asset
trades.
Intrinsic value represents the
price a security ought to have
based on all factors bearing on
valuation.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Valuation

4.7

Important Terms

Types of Bonds

Valuation of Bonds

Handling Semiannual
Compounding

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Important Bond Terms

4.8

A bond is a long-term debt


instrument issued by a
corporation or government.

The maturity value (MV)


MV [or face
value] of a bond is the stated
value. In the case of a US bond,
the face value is usually $1,000.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Important Bond Terms

4.9

The bonds coupon rate is the stated


rate of interest; the annual interest
payment divided by the bonds face
value.
The discount rate (capitalization rate)
is dependent on the risk of the bond
and is composed of the risk-free rate
plus a premium for risk.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Different Types of Bonds


A perpetual bond is a bond that never
matures. It has an infinite life.

V=

I
(1 + kd)1

t=1

(1 + kd)t

V = I / kd
4.10

I
(1 + kd)2

or

+ ... +

I
(1 + kd)

I (PVIFA k

d,

[Reduced Form]

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Perpetual Bond Example


Bond P has a $1,000 face value and provides an
8% annual coupon. The appropriate discount rate
is 10%. What is the value of the perpetual bond?
bond

= $1,000 ( 8%) = $80.


$80

kd

= 10%.
10%

= I / kd

[Reduced Form]

= $80 / 10% = $800.


$800
4.11

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Tricking the
Calculator to Solve
Inputs

1,000,000 10

N
Compute
N:
I/Y:
PV:
PMT:
FV:
4.12

I/Y

PV

80

PMT

FV

800.0

Trick by using huge N like 1,000,000!


10% interest rate per period (enter as 10 NOT 0.10)
Compute (Resulting answer is cost to purchase)
$80 annual interest forever (8% x $1,000 face)
$0 (investor never receives the face value)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Different Types of Bonds


A non-zero coupon-paying bond is a
coupon paying bond with a finite life.

V=

I
(1 + kd)1

t=1

(1 + kd)

V = I (PVIFA k
4.13

I
(1 + kd)2

+ ... +

I + MV
(1 + kd)n

MV
(1 + kd)n

) + MV (PVIF kd, n)

d, n

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Coupon Bond Example


Bond C has a $1,000 face value and provides
an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the
value of the coupon bond?
V

= $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)


= $80 (9.427) + $1,000 (.057)
[Table IV]

[Table II]

= $754.16 + $57.00
= $811.16.
$811.16
4.14

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Coupon


Bond on the Calculator
Inputs
Compute
N:
I/Y:
PV:
PMT:
FV:
4.15

30

10

I/Y

PV
-811.46

80

+$1,000

PMT

FV

(Actual, rounding
error in tables)

30-year annual bond


10% interest rate per period (enter as 10 NOT 0.10)
Compute (Resulting answer is cost to purchase)
$80 annual interest (8% x $1,000 face value)
$1,000 (investor receives face value in 30 years)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Different Types of Bonds


A zero coupon bond is a bond that pays
no interest but sells at a deep discount
from its face value; it provides
compensation to investors in the form
of price appreciation.

V=
4.16

MV
(1 + kd)n

= MV (PVIFk

d, n

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Zero-Coupon
Bond Example
Bond Z has a $1,000 face value and
a 30 year life. The appropriate
discount rate is 10%. What is the
value of the zero-coupon bond?
V

4.17

= $1,000 (PVIF10%, 30)


= $1,000 (0.057)
= $57.00
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Zero-Coupon


Bond on the Calculator
Inputs
Compute
N:
I/Y:
PV:
PMT:
FV:
4.18

30

10

I/Y

PV
57.31

PMT

+$1,000

FV

(Actual - rounding
error in tables)

30-year zero-coupon bond


10% interest rate per period (enter as 10 NOT 0.10)
Compute (Resulting answer is cost to purchase)
$0 coupon interest since it pays no coupon
$1,000 (investor receives only face in 30 years)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Semiannual Compounding
Most bonds in the US pay interest
twice a year (1/2 of the annual
coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2
4.19

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Semiannual Compounding
A non-zero coupon bond adjusted for
semi-annual compounding.

I
/
2
I
/
2
I
/
2
+
MV
V =(1 + k /2 )1 +(1 + k /2 )2 + ... +
2 n
d

2*n

t=1

I/2
(1 + kd /2 )

(1 + kd/2 ) *

MV
(1 + kd /2 ) 2*n

= I/2 (PVIFAkd /2 ,2*n) + MV (PVIFkd /2 ,2*n)


4.20

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Semiannual Coupon
Bond Example
Bond C has a $1,000 face value and provides
an 8% semi-annual coupon for 15 years. The
appropriate discount rate is 10% (annual rate).
What is the value of the coupon bond?
V

= $40 (PVIFA5%, 30) + $1,000 (PVIF5%, 30)


= $40 (15.373) + $1,000 (.231)
[Table IV]

[Table II]

= $614.92 + $231.00
4.21

= $845.92

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Semiannual Coupon


Bond on the Calculator
Inputs
Compute
N:
I/Y:
PV:
PMT:
FV:
4.22

30

I/Y

PV
846.28

40

+$1,000

PMT

FV

(Actual, rounding
error in tables)

15-year semiannual coupon bond (15 x 2 = 30)


5% interest rate per semiannual period (10 / 2 = 5)
Compute (Resulting answer is cost to purchase)
$40 semiannual coupon ($80 / 2 = $40)
$1,000 (investor receives face value in 15 years)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Semiannual Coupon
Bond Example
Let us use another worksheet on your
calculator to solve this problem. Assume
that Bond C was purchased (settlement
date) on 12-31-2004 and will be redeemed
on 12-31-2019. This is identical to the 15year period we discussed for Bond C.
What is its percent of par? What is the
value of the bond?
4.23

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Bond Problem


Press:

2nd

Bond

12.3104 ENTER
8

ENTER

12.3119 ENTER

10
CPT

ENTER

Source: Courtesy of Texas Instruments


4.24

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Semiannual Coupon
Bond Example

4.25

1.

What is its
percent of par?

84.628% of par
(as quoted in
financial papers)

2.

What is the
value of the
bond?

84.628% x $1,000
face value =
$846.28

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Preferred Stock Valuation


Preferred Stock is a type of stock
that promises a (usually) fixed
dividend, but at the discretion of
the board of directors.
Preferred Stock has preference over
common stock in the payment of
dividends and claims on assets.
4.26

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Preferred Stock Valuation


V=

DivP
(1 + kP)

DivP

+ (1 + k

DivP

t=1

(1 + kP)

P)

+ ... +

DivP
(1 + kP)

or DivP(PVIFA k

P,

This reduces to a perpetuity!


perpetuity

V = DivP / kP
4.27

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Preferred Stock Example


Stock PS has an 8%, $100 par value
issue outstanding. The appropriate
discount rate is 10%. What is the value
of the preferred stock?
stock
DivP
kP
V

4.28

= $100 ( 8% ) = $8.00.
$8.00
= 10%.
10%
= DivP / kP = $8.00 / 10%
= $80

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Common Stock Valuation


Common stock represents a
residual ownership position in the
corporation.
Pro rata share of future earnings
after all other obligations of the
firm (if any remain).

4.29

Dividends may be paid out of


the pro rata share of earnings.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Common Stock Valuation


What cash flows will a shareholder
receive when owning shares of
common stock?
stock
(1) Future dividends
(2) Future sale of the common
stock shares
4.30

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Dividend Valuation Model


Basic dividend valuation model accounts
for the PV of all future dividends.

V=

Div1
(1 + ke)1

Divt

t=1

(1 + ke)t

=
4.31

Div2
(1 + ke)2

+ ... +

Div
(1 + ke)

Divt: Cash Dividend


at time t
ke:

Equity investors
required return

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Adjusted Dividend
Valuation Model
The basic dividend valuation model
adjusted for the future stock sale.

V=

Div1
(1 + ke)1

n:
Pricen:
4.32

Div2
(1 + ke)2

Divn + Pricen
+ ... +
(1 + k )n
e

The year in which the firms


shares are expected to be sold.
The expected share price in year n.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Dividend Growth
Pattern Assumptions
The dividend valuation model requires the
forecast of all future dividends. The
following dividend growth rate assumptions
simplify the valuation process.

Constant Growth
No Growth
Growth Phases
4.33

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Constant Growth Model


The constant growth model assumes that
dividends will grow forever at the rate g.

D0(1+g) D0(1+g)2
D0(1+g)
V = (1 + k )1 + (1 + k )2 + ... + (1 + k )

D1
=
(ke - g)
4.34

D1:

Dividend paid at time 1.

g:

The constant growth rate.

ke:

Investors required return.

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Constant Growth
Model Example
Stock CG has an expected dividend
growth rate of 8%. Each share of stock
just received an annual $3.24 dividend.
The appropriate discount rate is 15%.
What is the value of the common stock?
stock
D1

= $3.24 ( 1 + 0.08 ) = $3.50

VCG = D1 / ( ke - g ) = $3.50 / (0.15 - 0.08 )


= $50
4.35

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Zero Growth Model


The zero growth model assumes that
dividends will grow forever at the rate g = 0.

VZG =

=
4.36

D1
(1 + ke)1

D1
ke

D2
(1 + ke)2

+ ... +

(1 + ke)

D1:

Dividend paid at time 1.

ke:

Investors required return.

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Zero Growth
Model Example
Stock ZG has an expected growth rate of
0%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What is
the value of the common stock?
stock
D1

= $3.24 ( 1 + 0 ) = $3.24

VZG = D1 / ( ke - 0 ) = $3.24 / (0.15 - 0 )


= $21.60
4.37

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases Model


The growth phases model assumes
that dividends for each share will grow
at two or more different growth rates.
n

V =

t=1

4.38

D0(1 + g1)
(1 + ke)

Dn(1 + g2)t

t=n+1

(1 + ke)t

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases Model


Note that the second phase of the growth
phases model assumes that dividends will
grow at a constant rate g2. We can rewrite
the formula as:

V =

t=1

4.39

D0(1 + g1)t
(1 + ke)t

Dn+1

(1 + ke)n (ke g2)

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
Stock GP has an expected growth
rate of 16% for the first 3 years and
8% thereafter. Each share of stock
just received an annual $3.24
dividend per share. The appropriate
discount rate is 15%. What is the
value of the common stock under
this scenario?
4.40

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
0

D1

D2

D3

D4

D5

D6

Growth of 16% for 3 years

Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%, starts


at time t=0 for 3 years and is followed by 8% thereafter
starting at time t=3. We should view the time line as two
separate time lines in the valuation.
4.41

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
0

D1

D2

D3

Growth Phase
#1 plus the infinitely
long Phase #2

D4

D5

D6

Note that we can value Phase #2 using the Constant


Growth Model
4.42

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
D
4
V3 =
k-g
0

We can use this model because


dividends grow at a constant 8%
rate beginning at the end of Year 3.

D4

D5

D6

Note that we can now replace all dividends from year 4


to infinity with the value at time t=3, V3! Simpler!!
4.43

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
0

D1

D2

D3

New Time
Line

Where
V3

D4
V3 =
k-g

Now we only need to find the first four dividends to


calculate the necessary cash flows.
4.44

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
Determine the annual dividends.
D0 = $3.24 (this has been paid already)
D1 = D0(1 + g1)1 = $3.24(1.16)1 =$3.76
D2 = D0(1 + g1)2 = $3.24(1.16)2 =$4.36
D3 = D0(1 + g1)3 = $3.24(1.16)3 =$5.06
D4 = D3(1 + g2)1 = $5.06(1.08)1 =$5.46
4.45

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
0

3.76 4.36 5.06


0

Actual
Values

3
78

Where $78 =

5.46
0.150.08

Now we need to find the present value


of the cash flows.
4.46

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
We determine the PV of cash flows.
PV(D1) = D1(PVIF15%, 1) = $3.76 (0.870) = $3.27
PV(D2) = D2(PVIF15%, 2) = $4.36 (0.756) = $3.30
PV(D3) = D3(PVIF15%, 3) = $5.06 (0.658) = $3.33
P3 = $5.46 / (0.15 - 0.08) = $78 [CG Model]

PV(P3) = P3(PVIF15%, 3) = $78 (0.658) = $51.32


4.47

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases
Model Example
Finally, we calculate the intrinsic value by
summing all of cash flow present values.

V = $3.27 + $3.30 + $3.33 + $51.32

V = $61.22
3 D0(1 +0.16)t

V=

t
(1
+0.15)
t=1

4.48

D4

(1+0.15)n (0.150.08)

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Intrinsic Value


Problem using CF Registry
Steps in the Process (Page 1)

4.49

Step 1:
Press CF
Step 2:
Press 2nd
Step 3: For CF0 Press

key
CLR Work keys
0
Enter
keys

Step 4:
Step 5:
Step 6:
Step 7:

3.76
1
4.36
1

For C01 Press


For F01 Press
For C02 Press
For F02 Press

Enter
Enter
Enter
Enter

keys
keys
keys
keys

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Intrinsic Value


Problem using CF Registry
Steps in the Process (Page 2)
Step 8: For C03 Press 83.06 Enter
Step 9: For F03 Press
1 Enter
Step 10:
Press

Step 11:
Press NPV
Step 12:
Press
15 Enter
Step 13:
Press CPT

keys
keys
keys

keys

RESULT: Value = $61.18!


(Actual - rounding error in tables)
4.50

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Calculating Rates of
Return (or Yields)
Steps to calculate the rate of
return (or Yield).
1. Determine the expected cash flows.
flows
2. Replace the intrinsic value (V) with
the market price (P0).
3. Solve for the market required rate of
return that equates the discounted
cash flows to the market price.
price
4.51

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Bond YTM


Determine the Yield-to-Maturity
(YTM) for the annual coupon paying
bond with a finite life.

P0 =

t=1

I
(1 + kd )t

= I (PVIFA k

MV
+

(1 + kd )n

) + MV (PVIF kd , n)

d,n

kd = YTM
4.52

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining the YTM


Julie Miller want to determine the YTM
for an issue of outstanding bonds at
Basket Wonders (BW). BW has an
issue of 10% annual coupon bonds
with 15 years left to maturity. The
bonds have a current market value of
$1,250.
$1,250
What is the YTM?
4.53

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution (Try 9%)

4.54

$1,250 =

$100(PVIFA9%,15) +
$1,000(PVIF9%, 15)

$1,250 =

$100(8.061) +
$1,000(0.275)

$1,250 =

$806.10 + $275.00

$1,081.10
[Rate is too high!]

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution (Try 7%)


$1,250 = $100(PVIFA7%,15) +
$1,000(PVIF7%, 15)
$1,250 = $100(9.108) +
$1,000(0.362)
$1,250 =

$910.80 + $362.00

= $1,272.80
4.55

[Rate is too low!]

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution (Interpolate)


0.02

0.07 $1,273
IRR $1,250

$23

$192

0.09 $1,081
X
0.02

4.56

$23
$192

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution (Interpolate)


0.02

0.07 $1,273
IRR $1,250

$23

$192

0.09 $1,081
X
0.02

4.57

$23
$192

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution (Interpolate)


0.02

0.07 $1273
YTM $1250

$23

$192

0.09 $1081
X = ($23)(0.02)
$192

X = 0.0024

YTM =0.07 + 0.0024 = 0.0724 or 7.24%


4.58

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution
on the Calculator
Inputs

15

N
Compute
N:
I/Y:
PV:
PMT:
FV:
4.59

I/Y

-1,250

100

+$1,000

PV

PMT

FV

7.22% (actual YTM)

15-year annual bond


Compute -- Solving for the annual YTM
Cost to purchase is $1,250
$100 annual interest (10% x $1,000 face value)
$1,000 (investor receives face value in 15 years)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Semiannual
Coupon Bond YTM
Determine the Yield-to-Maturity
(YTM) for the semiannual coupon
paying bond with a finite life.

P0 =

2n

t=1

I/2
(1 + kd

+
/2 )
t

= (I/2)(PVIFAk

MV
(1 + kd /2 )2n

) + MV(PVIFkd /2 , 2n)

d /2, 2n

[ 1 + (kd / 2)2 ] 1 = YTM


4.60

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining the Semiannual


Coupon Bond YTM
Julie Miller want to determine the YTM
for another issue of outstanding
bonds. The firm has an issue of 8%
semiannual coupon bonds with 20
years left to maturity. The bonds have
a current market value of $950.
$950
What is the YTM?
4.61

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

YTM Solution
on the Calculator
Inputs

40

N
Compute
N:
I/Y:
PV:
PMT:
FV:
4.62

I/Y

-950

40

+$1,000

PV

PMT

FV

4.2626% = (kd / 2)

20-year semiannual bond (20 x 2 = 40)


Compute -- Solving for the semiannual yield now
Cost to purchase is $950 today
$40 annual interest (8% x $1,000 face value / 2)
$1,000 (investor receives face value in 15 years)
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Semiannual
Coupon Bond YTM
Determine the Yield-to-Maturity
(YTM) for the semiannual coupon
paying bond with a finite life.
[ (1 + kd / 2)2 ] 1 = YTM
[ (1 + 0.042626)2 ] 1 = 0.0871
or 8.71%
Note: make sure you utilize the calculator
answer in its DECIMAL form.
4.63

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Bond Problem


Press:

2nd

Bond

12.3104 ENTER
8

ENTER

12.3124 ENTER

95
CPT

ENTER
= kd

Source: Courtesy of Texas Instruments


4.64

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining Semiannual
Coupon Bond YTM
This technique will calculate kd.
You must then substitute it into the
following formula.
[ (1 + kd / 2)2 ] 1 = YTM
[ (1 + 0.0852514/2)2 ] 1 = 0.0871
or 8.71% (same result!)
4.65

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price - Yield


Relationship
Discount Bond The market required
rate of return exceeds the coupon rate
(Par > P0 ).
Premium Bond The coupon rate
exceeds the market required rate of
return (P0 > Par).
Par Bond The coupon rate equals the
market required rate of return (P0 = Par).
4.66

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price - Yield


Relationship
BOND PRICE ($)

1600
1400
1200
1000
Par

5 Year

600

15 Year

0
0

8
10
12
Coupon Rate

14

16

18

MARKET REQUIRED RATE OF RETURN (%)


4.67

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price-Yield
Relationship
When interest rates rise,
rise then the
market required rates of return rise
and bond prices will fall.
fall
Assume that the required rate of return on
a 15 year, 10% annual coupon paying bond
rises from 10% to 12%. What happens to
the bond price?
4.68

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price - Yield


Relationship
BOND PRICE ($)

1600
1400
1200
1000
Par

5 Year

600

15 Year

0
0

8
10
12
Coupon Rate

14

16

18

MARKET REQUIRED RATE OF RETURN (%)


4.69

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price-Yield
Relationship (Rising Rates)
The required rate of return on a 15
year, 10% annual coupon paying
bond has risen from 10% to 12%.
Therefore, the bond price has fallen
from $1,000 to $864.
($863.78 on calculator)
4.70

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price-Yield
Relationship
When interest rates fall,
fall then the
market required rates of return fall
and bond prices will rise.
rise
Assume that the required rate of
return on a 15 year, 10% annual
coupon paying bond falls from 10% to
8%. What happens to the bond price?
4.71

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price - Yield


Relationship
BOND PRICE ($)

1600
1400
1200
1000
Par

5 Year

600

15 Year

0
0

10

12

14

16

18

Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)


4.72

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price-Yield Relationship


(Declining Rates)
The required rate of return on a 15
year, 10% coupon paying bond
has fallen from 10% to 8%.
Therefore, the bond price has
risen from $1000 to $1171.
($1,171.19 on calculator)
4.73

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Role of Bond Maturity


The longer the bond maturity, the
greater the change in bond price for a
given change in the market required
rate of return.
Assume that the required rate of return
on both the 5 and 15 year, 10% annual
coupon paying bonds fall from 10% to
8%. What happens to the changes in
bond prices?
4.74

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Bond Price - Yield


Relationship
BOND PRICE ($)

1600
1400
1200
1000
Par

5 Year

600

15 Year

0
0

8
10
12
Coupon Rate

14

16

18

MARKET REQUIRED RATE OF RETURN (%)


4.75

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Role of Bond Maturity


The required rate of return on both the
5 and 15 year, 10% annual coupon
paying bonds has fallen from 10% to
8%.
The 5 year bond price has risen from $1,000 to
$1,080 for the 5 year bond (+8.0%).
The 15 year bond price has risen from $1,000 to
$1,171 (+17.1%). Twice as fast!
4.76

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Role of the


Coupon Rate
For a given change in the
market required rate of return,
the price of a bond will change
by proportionally more, the
lower the coupon rate.

4.77

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of the Role of


the Coupon Rate
Assume that the market required rate of
return on two equally risky 15 year bonds
is 10%. The annual coupon rate for Bond
H is 10% and Bond L is 8%.
What is the rate of change in each of the
bond prices if market required rates fall
to 8%?
4.78

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of the Role of the


Coupon Rate
The price on Bond H and L prior to the
change in the market required rate of
return is $1,000 and $848 respectively.
The price for Bond H will rise from $1,000
to $1,171 (+17.1%).
The price for Bond L will rise from $848 to
$1,000 (+17.9%). Faster Increase!
4.79

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining the Yield on


Preferred Stock
Determine the yield for preferred
stock with an infinite life.
P0 = DivP / kP
Solving for kP such that
kP = DivP / P0
4.80

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Preferred Stock Yield


Example
Assume that the annual dividend on
each share of preferred stock is $10.
Each share of preferred stock is
currently trading at $100. What is the
yield on preferred stock?
kP = $10 / $100.
kP = 10%.
10%
4.81

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determining the Yield on


Common Stock
Assume the constant growth model
is appropriate. Determine the yield
on the common stock.
P0 = D1 / ( ke g )
Solving for ke such that
ke = ( D1 / P0 ) + g
4.82

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Common Stock
Yield Example
Assume that the expected dividend
(D1) on each share of common stock
is $3. Each share of common stock
is currently trading at $30 and has an
expected growth rate of 5%. What is
the yield on common stock?
ke = ( $3 / $30 ) + 5%

ke = 10% + 5% = 15%
4.83

Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.